Debt is the Cheapest Source of Financing

Debt financing

Debt financing is the act of raising operating capital or other capital by borrowing for a business. Most often, this refers to the issuance of a bond, debenture, or other debt security.

When a company takes a loan from the third party then it is considered as debt financing. It is one of the most commonly used ways of financing. Debt can be of short-term, mid-term and long-term.

debt is the cheapest source of financing

Capital Structure

Why debt is the cheapest source of financing?

A company can manage its required funds through debt or equity or combination of both. Choosing an optimal capital structure different company uses a different ratio of debt and equity. But the question is how an optimal capital structure can be formed. Basically, the capital structure is formed by considering the financial strength of the company and cost of funds from different sources.

Many people say that retained earnings are the cheapest source of financing but debt can be the cheapest source of financing from different perspectives. From the share holder’s perspective tax deductibility feature of debt, finance is lucrative. And from the lenders perspective debt is secured because creditors get the preference of getting their principal and interest before making any benefit to the shareholders.

Tax deductibility feature of debt is the main point, on which we can say debt is the cheapest source of financing.

There are some other points that may include with deductibility feature. These are

  • Time value of money and preference for funds.
  • Dividends not payable to lenders
  • Interest rate.

Let us consider an example to show how debt financing helps to reduce the tax burden that is the tax deductibility features of interest.

Example: Suppose XYZ company take a loan of $1000000from ABC bank at the rate of 15%. Tax payable to the government is 30% of the income. Income is = $500000

Only Equity is used

If there is no debt financing then XYZ company has to pay tax of total = $500000 X 30% = $150000

After-tax income = $ 500000 – $150000 = $350000

If Debt and equity is used

On the other hand, if company use debt financing then,

Interest on loan amount = $1000000 X 15% = $150000

Taxable income is = $500000 – $150000 = $350000

Tax payable = $350000 X .3 = $105000

After-tax income is = $500000 – $105000 = $395000

From the example, it is clear that because of debt financing XYZ Company is paying less amount of tax which increases the net income after tax. Normally company making a profit of $350000 but because of using Debt Company is making a profit of 395000. That’s why company prefers debt financing.

Let us consider another example: XYZ company take a loan at the rate of 14% and the corporate tax rate is 30%.

Here the cost of debt capital is 14% but because of using debt capital company’s cost of capital for debt is 14 X (1 – 30%) = 9.80%. Cost of capital is reduced because of tax deductibility feature of debt financing.

So we can say that debt can be the cheapest source of financing for the company.

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Written by

Md. Nahian Mahmud Shaikat

Financial Analyst

Institute of Business Administration (IBA)

Jahangirnagar University

Email: nahian.mahm[email protected]

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